Captives: A Shadow Insurance Industry?

New York State Superintendent of Financial Services Benjamin
Lawsky has produced a report after 11 months of investigation
that declares captives to be a "shadow insurance industry." He
has called for a nationwide moratorium on licensing new
captives. His report and press release have been picked up by,
among others, the New York Times. Many writers
have jumped on his bandwagon.

Fortunately, cooler heads are
prevailing. James Donelon, the chair of the National Association
of Insurance Commissioners (NAIC), has called Mr. Lawsky's
comments a "knee-jerk reaction." Other regulators have rejected
the call for a moratorium. Many regulators are ignoring him
altogether.

Background

By way of explanation and
background, Mr. Lawsky was originally looking into the practice
of many life insurers of taking excess, redundant reserves,
placing them into a captive, and selling the ownership to
investors for an increased return. These transactions fall under
the NAIC Section XXX and AXXX and are allowed, encouraged,
perfectly legal, and aboveboard.

These reserves are seen as
redundant by all regulators because, while life insurers are
required to reserve for future payouts, it is widely accepted
that many policyholders will let their insurance lapse or nonrenew, making reserves for those policies not needed.
Actuaries for the life insurers and the NAIC all agree on that
point, including the New York Department of Insurance.

Some
clever person saw that, since these reserves have value, they
could be converted into a commercially saleable asset. So, the
idea arose that the reserves could be put into a captive, and
the captive, now with secure assets, could sell ownership
interests to outside investors. We are talking about hundreds of
millions of dollars here. The reserves are invested in assets
that produce potentially higher returns than what would be in a
traditional captive or sitting flat on the insurer's books.

These captives are so large that, when licensed, they
immediately pay the full tax to the maximum limit. This benefits
the domicile.

So, what is the issue? Some within the NAIC feel
that the redundant reserve problem could be solved another way
without a captive. They have formed the inevitable committee to
investigate. This is not Mr. Lawsky's investigation. The NAIC
may have a point, but so far no evidence has shown a big
advantage one way or the other. Of course, the NAIC continues to
investigate. That's what it is designed to do.

One can only
speculate as to why Mr. Lawsky and his staff, as well as the
New
York Times and other uninformed commentators,
would not be aware of the above explanation.

Mr. Lawsky
maintains that the life insurers use captives as a "black box"
to hide their transactions. He asserts that, since the captives
are not domiciled in New York, they are lightly regulated. He
says this about Vermont, Bermuda, Cayman, South Carolina, and
Missouri, all of which, it can be argued, are better captive
regulators than New York. He makes the "black box" claim even
though all of these life insurers are audited, file annual
reports with him and all domiciles in which they do business,
and are examined by the Securities and Exchange Commission and
countless other regulatory bodies. Many are domiciled in New
York and file volumes of information with the New York
Department quarterly. The captives may not show on the insurers'
balance sheets, but they are in the notes. Regulators know about
them.

Effect of Accusations

The concern is that this story
won't go away and affects all captives. Not a day passes without
a comment by an uninformed observer of the industry that gets
picked up and blown all over the Internet. If commentators don't
understand the XXX/AXXX issue, then they certainly won't
understand that a captive owned by an association of bricklayers
is completely unlike a life insurer's captive. If they think
that Vermont regulates captives lightly, then they will never
understand that captives are different from traditional
insurers. Captives are not required to file all of the
voluminous reports required of traditional insurers because they
are a form of self-insurance. Their exposure to
loss is their own.

If an institution like the New York
Times can mindlessly publish a critical article
without, apparently, a smattering of independent research or any
understanding (even their parent company owns a captive), then
it is not surprising that others give the story credence without
any facts or understanding.

Conclusion

As you encounter
these stories, please bear in mind that life insurer captives
are closely regulated; the reserves invested are redundant and
don't threaten policyholder claims; there is no black box or
shadow industry. In my opinion, anyone saying otherwise simply
doesn't know of what they speak. Beware of what else they may be
saying on other subjects as they are so wrong on this one.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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